Fed's Discount-Rate Increase Illustrates Exit-Strategy Challenges That Await the U.S. Central Bank

Is the U.S. Federal Reserve finally launching its "exit strategy?"

When the nation's central bank boosted the discount rate last week, it assured investors that this wasn't a monetary tightening. The assurance didn't seem to matter. The move late Thursday touched off a furious global-market reaction and U.S. dollar increase on Friday. This demonstrates the challenge the central bank will face as it crawls toward an ultimate increase in interest rates.

In a move that surprised the markets, the Fed announced Thursday that it was increasing the rate it charges banks for emergency loans to 0.75% from 0.50%. The also reduced the central bank also slashed the maximum-loan-maturity length from 28 days (it was once as high as 90 days) to overnight.

The announcement hammered global stocks and worldwide commodity prices and boosted the greenback. Futures traders ramped up their bets that the central bank will boost the benchmark Federal Funds short-term interest-rate target by September – even though policymakers have said the Fed wants to maintain that super-low target for "an extended period."

"To some extent, the market's reaction must be quite perturbing to the Fed," Alan Ruskin, head of currencies for RBS Global Banking and Markets (NYSE ADR: RBS), told Reuters. "The concern from the Fed must be, 'Now what happens when we really want to do something substantive?'"
Federal Reserve Chairman Ben S. Bernanke has insisted this was not a tightening of monetary policy, but a return to normalcy.

"Like the closure of a number of extraordinary credit programs earlier this month, these changes are intended as a further normalization of the Federal Reserve's lending facilities," the Fed said in the statement that announced the discount-rate increase.

The rate increase does two things that do indeed promote "normalcy" in U.S. monetary policy: It increases the spread between the discount rate and the Fed Funds rate, which has been as low as 0.25% but is usually 1%; and it encourages depository institutions to use the discount window as back-up fund source only. 

The "extraordinary" alterations in the discount window lending procedure were considered necessary in 2008 to prevent further economic disruption. Now that the U.S. economy's situation is not at the red-alert emergency level, these temporary measures have served their purpose and have no reason to remain in force.

Friday's headlines about the Fed's move spread fear that the rate hike would lead to a sooner-than-later Fed Funds rate increase, which would limit individuals and businesses from borrowing and could possibly lose some ground gained in economic growth.

But Pimco's Bill Gross, a noted expert on the fixed-income markets, doesn't see drastic rate changes soon to follow: "I don't think the Fed dares increase the fed funds or policy rate in the face of unemployment at double-digit type of levels. This is more of a technical maneuver," he told Reuters Insider television.

Most insiders see this move as the beginning of the Fed's exit strategy, which Bernanke outlined in the Fed's prepared statement on Feb.10. The exit strategy is designed to wean the economy off its dependence on special stimulus measures created during crisis height in 2008.

If the Fed operates in line with the proposed strategy, it will start absorbing the extra reserves pumped into the banking system. One maneuver is the reverse repurchasing agreement, where the Fed sells securities from its portfolio and agrees to buy them back at a higher price at a future date. Another is a term deposit facility, which would operate similar to certificates of deposit, and would convert part of institution's reserve balances' into deposits not to exceed one year.

Thursday's announcement shows the wheels are in motion toward a less-accommodating monetary policy than the current system, but one that promotes healthy lending and financial sustainability.

News and Related Story Links:

• Reuters:
  Rate hike furor shows delicate task ahead for Fed.
• Wikipedia:
  Discount Rate.